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July 16, 2013

What the Pros Expect From Stocks and Bonds for the Second Half

As we slide past the midway point of 2013, the stock market has just produced its first negative, not to mention most volatile, month in the last eight. On the fixed income side, the exit from bond funds was proceeding at the highest levels since 2008, while overseas, politics and bank problems were reviving concerns about Europe’s sovereign debt crisis and its effects on global investor sentiment. For investment thrill seekers, the resulting volatility at period end was probably a lot of fun.

Actually, the first half of the year included enough thrills and chills for just about any investor. The bigger question now is whether we have to keep the seatbelts fastened for the second half. While there are lots of opinions on the near-term prospects for the global markets, there are none more valuable than those of investment managers with ‘skin in the game.’ As a provider of qualitative manager research and due diligence, we’re fortunate enough to be in constant contact with separate account and mutual fund managers competing in their marketplaces on a daily basis. What these professionals say matters, and here’s what we’re hearing them say. Here’s a sampling.

Consensus Viewpoint: It’s an overworked expression to be sure, but the majority of domestic managers we talk with are ‘cautiously optimistic’ on U.S. stocks. And for good reason: There are plenty of things to like here at home. Among the positives on the U.S. are strong market fundamentals, a slowly improving economy, increased consumer spending resulting from the housing and stock market rebound, and the significant amount of cash larger firms have accumulated for mergers and acquisitions. There are reasons for caution, too, and managers expressed real concern that a reduction in quantitative easing could cause the economy to stall or even contract. Professional investors also noted that with margins near all-time highs, earnings growth will be impossible without top-line growth from economic expansion. China and Europe lurk in the background with potential to derail U.S. growth.

The Outlier POV: The outlier viewpoint on the U.S. is that massive debt and quantitative easing coupled with political gridlock will bring about another stock market crash and push the economy back into recession. Worst case, the Fed and U.S. government will be “out of bullets” to stimulate the economy leading to a long period of sustained economic suffering.

Consensus Viewpoint: Within the international equity arena, the most prominent view of managers we talk with is optimism toward emerging markets (EM) equities. Managers commonly point to myriad fundamental factors in EM countries that are supportive of their view, including GDP growth nearly double that of developed countries, a large and quickly growing middle class that should dramatically increase domestic consumption, a fiscal surplus that starkly contrasts with fiscal deficits across developed countries, valuations that are as cheap as they’ve been in the past three years, the continued need for EM infrastructure investment that should accelerate GDP growth, and the strengthening inter-EM trade that should lessen reliance upon more sluggish developed economies. As a result, many managers under our coverage maintain significant allocations to EM equities.

The Outlier POV: Contrarily, a few managers with whom we speak point to a slowing Chinese economy, continued discomfort arising from the Euro crisis, recent declines in EM profitability, and slowing EM GDP levels. These managers have reduced exposure to EM equities.

Consensus Viewpoint: On the bond front, most domestic fixed income managers appear to be preparing for heightened volatility stemming from the Fed’s potential ‘tapering’ and continued economic uncertainty in the U.S. and Europe. Amid already tight spreads, many managers have been moving up the quality spectrum within their portfolios and moving duration closer to that of their respective benchmarks. In addition, some managers have been increasing their cash position to help mitigate portfolio volatility, manage potential outflows, or to fund opportunities that may arise as riskier assets are periodically sold off.

The Outlier POV: Away from the consensus, there are managers forecasting worse-than-expected economic outcomes and a lack of Fed tapering until mid-2014 at the earliest. Reasons for such an outlook include the lack of catalysts to bring down unemployment and boost GDP, an absence of inflation, and the end of Fed Chairman Bernanke’s term in early next year. Strategically, these managers are more likely to focus on the lower quality segment of the high yield market, where valuations are less sensitive to technical factors in the market.

Summing Up: Watch Your Managers

Given the magnitude of disagreement among professional investment managers and the markets they observe, the ‘return to volatility’ that marked the end of 2013’s first half may well have set the stage for its second. There is no clear or easy approach, in other words, and the thrills and chills are likely to continue.

We believe the next six months hold the prospect for real investment gains in important markets like U.S. stocks, international equities and domestic fixed income. They also hold the potential for real surprise. We can’t imagine a time when it was more important to carefully monitor the managers you’ve selected to run your clients’ investments. The second half of 2013 is going to be a tough one to navigate – stick with managers that stay true to their style, their stated objectives, and their overall philosophy. And keep your seat belt buckled.

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Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.

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